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Chapter 11Earnings Management

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Organization of This Chapter

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What Is Earnings Management (EM)?

Earnings management is the choice by a manager of accounting policies (including accruals), or real actions, that affect earnings so as to achieve some specific reported earnings objective.

Here, we concentrate on role of accruals in earnings management.

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Patterns of EM

Four common patterns of EM:

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Motivation for EM: Bonus Purposes

A contractual motivation: bonus plan hypothesis Evidence: Healy (1985)

Confined to bonuses based on net income Recall concepts of bogey and cap Findings (see table on next slide):

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Motivation for EM:Bonus Purposes (cont.) Healy (1985) (cont.)

Observations with both a Bogey and a Cap

Portfolio

Proportion of Accruals with

Given Sign

No. of Obs.

Average

Accruals

Positive Negative

LOW 9% 91% 22 - 0.0671

MID 46% 54% 281 +0.0021

UPP 10% 90% 144 - 0.0536

447

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Motivation for EM:Bonus Purposes (cont.)

Healy (1985) (cont.) Methodological issues of measuring discretionary

accruals Healy used total accruals as proxy Now usually based on Jones (1991) model Result of downward earnings management when

net income below bogey challenged by Holthausen, Larcker, and Sloan (1995)

Conclusion: despite methodological challenges, there is significant evidence that, on average, managers uses accruals to manage earnings so as to influence their bonuses

Other Motivations for EM

Other contractual motivations Debt covenant hypothesis

To avoid violating debt covenants Implicit contracts

To maintain continuing business relationships with other stakeholders, such as suppliers and short-term creditors

Political cost hypothesis: to lower political “heat”

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Other Motivations for EM (cont.)

Stock market related motivations: To meet investors’ earnings expectations

and maintain manager reputation To increase proceeds from stock

issuance, especially initial public offerings Teoh, Welch, and Wong (1998) Fan (2007)

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The Good Side of EM

Investor-based arguments for good EM To credibly communicate inside information to

investors Blocked communication may inhibit direct

disclosure of earnings expectations

Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations

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The Good Side of EM (cont.)

Contract-based arguments for good EM To give firm some flexibility in the face of rigid, incomplete

contracts, thus improving contracting efficiency Bonus contracts based on net income

New accounting standards may lower net income and/or increase volatility

Hence may adversely affect evaluation of manager effort

Debt covenant contracts New accounting standards may increase probability of debt

covenant violation Contract violation is costly, earnings management may be

low-cost way to work around

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The Good Side of EM (cont.)

Theoretical models supporting good EM Demski & Sappington (1987a & b) Chen, Hemmer, & Zhang (2007)

Empirical evidence supporting good EM Subramanyam (1996) Barth, Elliott, & Finn (1999) Tucker & Zarowin (2006) Francis, LaFond, Olsson, & Schipper (2005) Etc.

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EM at General Electric Textbook, problem 9 GE’s Steady Increase in Reported Earnings

Year Reported Net Income

(Million)

Year Reported Net Income

(Million)

2008 $17,335 2000 $12,735

2007 22,208 1999 10,717

2006 20,829 1998 9,296

2005 16,711 1997 8,203

2004 17,160 1996 7,280

2003 15,002 1995 6,573

2002 14,118 1994 4,726

2001 13,684 1993 4,315

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EM at General Electric (cont.)

GE’s Reported Net Income (Million) from 1993 to 2008

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EM at General Electric (cont.)

EM devices used by GE Changes to the expected rate of return on

pension plan assets Sales of divisions Restructuring charges Conservative accounting Allocation of purchased goodwill upon acquisition

of subsidiary companies

EM devices used in harmony to report steadily increasing earnings

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EM at General Electric (cont.)

Is this good or bad (i.e., opportunistic) EM? Argument: even assuming securities market

efficiency, GE is so large and complex that even financial analysts cannot prepare accurate earnings forecasts Management has best inside information

about expected persistent earnings Direct communication blocked Creates role for earnings management to

reveal management’s expected persistent earnings

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The Bad Side of EM

Contracting Perspective Healy (1985)

Related to manager’s bonus plans Is this good or bad earnings management?

Dechow, Sloan, and Sweeney (1996) 92 sample firms charged by SEC with alleged

violation of GAAP Related to avoiding debt covenant violation and

issuing stocks Is this good or bad earnings management?

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The Bad Side of EM (cont.)

Financial Reporting Perspective Hanna (1999) re. non-recurring charges

Investors and analysts look to core earnings, ignoring provisions for extraordinary and non-recurring items

But current non-core provisions increase core earnings in future years, through lower amortization and absorption of future operating costs

As a result, managers tempted to “overdose” on non-core provisions, thereby putting earnings “in the bank” (“cookie jar accounting”)

Decision useful financial information to investors?

The Bad Side of EM (cont.)

Standard setters response to bad EM IAS 37 on provisions for uncertain future

payment Before recording a provision, payments must be

probable and capable of reliable estimation Provision must be valued at fair value No excess provision as a result of uncertainty Provisions must be used only to absorb costs for

which provision originally set up Restructuring expense and any reversals thereof must

be shown separately on the income statement

Does this solve problem of abuse of provisions?

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The Bad Side of EM (cont.)

Can accountants reduce bad EM? Yes, if full disclosure of

Revenue recognition policies Unusual, non-recurring and extraordinary

events Enables investors to better evaluate earnings persistence

Effect of previous non-recurring charges on current core earnings (Hanna,1999)

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Conclusions

Earnings management can be good if used responsibly

Full disclosure helps to control bad earnings management